Bonds, while returning 2 per cent per year above inflation, have not kept pace with stocks over the long run, which have returned nearly triple the real return of bonds over this period.
The impact on your wealth with such a divergence in real returns could be the difference between being able to retire comfortably or not.
So, with this evidence to hand, the question is whether bonds should be viewed differently now.
Historical returns in excess of inflation since 1926 to 2022
Viewing bonds in a new light
In a higher inflation and interest rate environment, bonds should indeed be viewed differently, but not for the reason you may think.
Firstly, bonds do now offer an absolute return, a very different starting point from a few years ago where they offered you close to nothing.
Focusing on this aspect alone makes bonds more attractive.
This, however, does not make them attractive enough for me to start reducing stock allocations to fund fixed income to the degree that the traditional 60/40 portfolio allocation is reversed.
Secondly, while inflation and interest rates are higher, this typically means that bond returns can also be expected to be more volatile than we have been used to over the past 25 years.
When looking at it from a portfolio optimisation perspective, it means bonds are less attractive in an overall portfolio when we consider risk-adjusted returns. It would be wise to assume bonds will have a higher expected correlation to equities in this environment.
We also need to assess what risk matters to investors: short-term volatility reduction or the ability to achieve longer-term wealth goals by growing their assets in real terms.
However, all is not lost for bonds. In a world with inflation surprises, inflation-linked bonds – especially those that can bought directly – could potentially provide a hedge against inflationary pressures as they pay you more if inflation rises.
So, in this sense, an unique asset class has the opportunity to come to the fore and complement traditional non inflation-linked nominal bonds.
While the classic 60/40 portfolio may need to be reassessed considering the current economic environment, a simple reversal to a 40/60 allocation may not be the optimal solution, especially when considering long-term wealth creation outcomes.
A more nuanced approach might be required, considering factors such as investment horizon, stock-bond correlation, and the volatility of the bonds themselves.
As investment managers, we need to remain adaptable, reassessing our strategies in response to changing market conditions.
The current economic climate offers an opportunity to reassess the role of bonds in our portfolios and to explore other asset classes – such as alternatives earning more than cash – that can provide diversification and return potential, particularly if the diversifying role that bonds have played in the past 20 years reverts to what long-term data suggests.
